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Since volatility has jolted markets recently, it is important to take a step back and think about some fundamentals in the economy. Economies are so complex that they are often hard to comprehend without breaking them into smaller pieces. Though the markets had previously kept a keen eye on the Federal Reserve meeting minutes, that obsession seems to have faded. Let us examine a few key components of what drives inflation.

Monetary policy vs. fiscal policy

Monetary policy is the control of the money supply by a countries monetary authority. The goals of monetary policy are focused on a target inflation rate or interest rate to ensure economic stability for the economy. As the wild price swings of bitcoin make the currency suboptimal, monetary policy attempts to control the opposite.

Fiscal policy, however, is the government’s use of taxes and expenditures in order to affect the economy. This includes stimulus packages, tax breaks, or even general laws that may impact the economy. Watching the Federal Reserve meeting minutes is an acute focus on monetary policy. This has given way to a focus on recent fiscal policy changes that have propelled the stock market to unprecedented heights.

Price inflation

At other points, the market has stumbled and oscillated frequently with news of price inflation. Price inflation is the rise of the price of consumer goods and services. If price inflation gets too high, markets react poorly because as prices rise there is an effective decrease in purchasing power.

There is a very fine line, however, between inflation that is too high and inflation that is seen as appropriate. The right levels of inflation are positive because of the basics of supply and demand.

Going back to the basics of economics, changes to supply and demand govern the prices and quantity of goods. For the classic example, if a frost kills half of the orange crop in a winter, the supply shrinks while the demand holds steady. This, in turn, forces consumers to pay more due to the scarcity of the good.

The previous example is one way that prices can inflate, but that is obviously not ideal. The desired price inflation comes from increased demand due to consumers having more money to spend on goods and services. This type of inflation indicates a healthy economy that is growing.

It is imperative to remember to think about the basics in the economy. Some of the most basic building blocks of our economy can have the largest impact. Simplifying a complex system like the economy provides great value in understanding it.

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